The rogue trading incident at UBS
that led to a £29.7 million fine for the Swiss bank may cause a further
contraction of prop trading activity, further limiting access to liquidity for
the buy-side.

A joint investigation by the UK’s
Financial Services Authority and Switzerland’s FINMA uncovered a number of
failings at UBS that allowed Kweku Adoboli, a former trader for the bank’s
London-based global synthetic equities division, to incur and disguise losses
totalling US$2.3 billion between June and September 2011. The losses were
accumulated on exchange-traded index futures and hidden by the use of late
bookings of real trades, booking of fictitious trades to internal accounts and
the use of fictitious deferred settlement trades.

"Failures of this type in
firms of the size and standing of UBS not only damage the firms concerned but
also wider confidence in the integrity of the markets and the financial
system,” said Tracey McDermott, director of enforcement and financial crime,
FSA. “It is imperative that the markets we regulate are seen by investors to be
orderly and a safe place to do business.”

Last week, Adoboli was jailed
for seven years after being found guilty on two counts of fraud by Southwark
Crown Court, London.

In a trading environment that
is already beset by lower market activity and increased regulatory pressure,
some buy-side traders believe that the incident may affect the way large brokers
facilitate client trades.

“This incident is likely to lead
to a further contraction of the big risk books held by banks, which will mean
the willingness of the large full-service brokers to commit capital will be
severely diminished,” Tony Whalley, investment director, head of derivatives
and equity dealing at Scottish Widows Investment Partnership, told
theTRADEnews.com. “The reduction in liquidity stemming from the shrinking of
banks’ prop desks will be exacerbated by on-going regulatory pressure and the
shrinking attraction of equities, as investors increasingly favour bonds and other
fixed income instruments.”

Banks that take deposits are
facing a limitation of their proprietary trading activities in both the US and
Europe. The Volcker rule included in the US Dodd-Frank Act bans deposit-taking
institutions from engaging in prop trading, while Europe is still mulling
whether to impose a similar separation following the recent publication of the
Liikanen review. The report, authored by Finnish central bank governor Erkki
Liikanen, recommended that banks with
trading assets exceeding €100 billion, or 15-25% of total assets, should
separate retail banking from prop trading. Meanwhile, Basel III, the latest set
of capital constraints to be imposed following the financial crisis, will make
it more costly for banks to hold risky assets on their balance sheets.

Looking inwards

But the sheer amount of new
regulation on capital requirements could mean that greater attention is instead
focused on internal risk management controls.

“Banks will take action based
on the UBS case but it is more likely to focus on enforcing stringent criteria
for employees that have access to proprietary capital,” said Simmy Grewal,
senior analyst at Aite Group. “I hope this incident highlights the need for
better internal risk measures that cant just be clicked through and ignored.”

The FSA noted that supervision
of front-office activities with UBS’ global synthetic equities division was
lacking and that excessive risk taking on the desk was not actively discouraged
or penalised.

The UBS case has also led to
further scrutiny on the use of synthetic exchange-traded funds (ETFs), the
instruments used by Adoboli that replicate the exposure of sectors or a
collection of securities without holding the underlying assets. Synthetic ETFs
use swaps and derivatives to replicate an exposure and can lead to greater
counterparty risk as the underlying instruments used are typically unknown to
the end investor.

"The
incident has again highlighted the opacity of synthetic ETFs and I would expect
it to result in a further move away from these instruments in favour of
physical ETFs,” said Paul Squires, head of trading at AXA Investment Managers.

But while investors appear to be favouring
physical ETFs – providers Lyxor and db x-trackers both announced the launch of
their first physical ETFs in recent months – the wider range of exposures
synthetic instruments offer mean they will continue to be sought after by
investors.

“Synthetic exposures wont ever go away,
especially with things like the financial transaction tax, which are leading
investors to seek alternatives to equities,” added Grewal.